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November 11, 2008

Scarcity of Capital to Increase

By James Ramage

As the investment bank era ends, so too, some in the industry are saying, the era of broad capital use for executing trades comes to a close.

For most buyside traders in the institutional equities space, there will be less capital available to facilitate large block trades, industry experts say. And when it is used, they add, it will be more expensive and employed more carefully.

One veteran block trader with decades of experience at a bulge bracket firm, who declined to give his name, said it's highly unlikely that any of the remaining large trading houses-including Goldman Sachs, JPMorgan and Bank of America-are going to take down large sums of risk from customers in the foreseeable future. The severe volatility alone, he said, makes it nearly impossible to hedge oneself properly when taking on bigger risks.

"Now, if you take on risk in a stock, the stock can drop $2 to $3 in your face and you're long 500,000 shares, and you're just dead," he said. "It's not worth doing it."

Before the subprime-induced credit crunch began to pummel financial markets in August 2007, the bulge bracket investment banks had extended vast amounts of capital to the buyside to facilitate trades. While the capital cemented the relationship, the investment banks made money by offering the buyside other services, said Dushyant Shahrawat, research director at the financial consulting firm TowerGroup.

Large commercial banks and second-tier brokerages also offered capital, he added, but to a far lesser extent.

The credit crunch throttled the balance sheets of the independent investment banks. And because none of them emerged unscathed, the buyside's ability to obtain capital has since narrowed considerably.

This is because the survivors are now likely to be more risk-averse in their current incarnation as federally regulated bank holding companies, Shahrawat said. Merrill Lynch, Lehman and Bear, each now part of a giant commercial bank, will likely have their capital commitment powers reined in as well.

"When you're under the Federal Reserve's purview, that might turn the heat on what you can and cannot do with the capital that you have," Shahrawat added, "because it's not capital you have raised through investors or commercial paper. It's depositor capital."

As banks and other financial institutions have fallen, uncertainty has run amok, particularly in the equities market. This, in turn, has awakened the volatility that had been raging and slumbering periodically since August 2007. However, this latest, most virulent strain-since Sept. 15-continues to storm upward and set new records on the Chicago Board Option Exchange's Volatility Index.

The extraordinary volatility has widened spreads and made trading large blocks of stock an extremely risky proposition, industry experts say. As that volatility is reflected in pricing for capital, the conditions are anything but ideal for using capital for large block trades.

The head trader at a large investment management firm said that the business for large blocks in excess of $100 million started shrinking when bank write-offs began in late 2007.

"I think that game changed a lot," he said. "I do believe [capital] left, but it left more in size and in price. Costs of capital widened out, plus the competitive landscape changed overnight. I think it's still there, but I believe it's smaller in scope."

Still, UBS and others will offer capital to their buyside clients. But UBS is doing so with an eye toward the volatility and prudence, said Robert Harrington, its managing director for U.S. Cash Equity Trading.

Routine capital isn't going anywhere, Harrington said, even in tight markets. And block capital remains an important part of UBS's offering, as well.

"Well, there might be fewer people doing it, but I don't see it completely drying up," Harrington said of capital for routine trades. "That's kind of a staple of the business, and even in the tight markets, you're there to provide liquidity to the clients prudently."

Ultimately, even if the amount of capital commitment stays the same for some firms, logic dictates that the absence of a Bear Stearns and a Lehman means that less capital is available throughout the industry overall. And the credit crisis has also made brokers wary of using their balance sheet to facilitate trades.

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